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Wednesday, 8 June 2011

Out of the Box - Graphic of the Day – Why Hedge Funds Will Continue to Grow

One of the advantages of looking at the activities of institutional investors is that their behaviour follows decision-making which stands for years at a time. The Investment Committee of a pension plan changes the strategic asset allocation say every 5 or more years. There may be a decision made to have 25% of plan assets in domestic equities with a tactical band of 20-30%, which allows for variation on an annual basis away from the central tendency of 25%. But for most of the time over six or seven years the plan assets will be around 25% in domestic equities from that point onwards, after a period of implementation.

The implementation of the change in asset mix will often take place over a year or more as mandates are changed, contractual notice is given to the money managers with the mandates, and the underlying assets are bought and sold. Allocations to domestic equity have tended to shrink over recent years, so the process might involve a plan sponsor giving six month notice to a Trust Bank that their mandate will halve in size, and then, in six months time the bank will liquidate a portion of their large cap mutual fund and transfer the cash to the pension plan's administrators.

The reverse process is expected to happen for hedge fund allocations over the next few years if the survey of investment consultants by Casey Quirk and eVestment Alliance is to be believed. The survey*, conducted in Dec 2010 and January 2011, asked investment consultants to forecast investment preferences and buying behaviour among North American institutional investors during 2011. One of the key trends that Casey Quirk identified was "The increasing role of heretofore "alternative" investments—hedge funds, private equity and real estate—which are emerging as the centerpiece of active asset management moving forward."

This trend in the use of alternatives reflect the new frameworks with which institutional investors and their consultants are building portfolios, with exposure defined less by product packaging or home bias, and more by the specific contributions investments make toward overall objectives. The framework is part of the new emerging paradigm for asset allocation amongst investing institutions in North America, shown in the Graphic of the Day below, and which will reinforce hedge fund growth.

Graphic of the Day - Hedge Funds Break out of The BoxThe Emerging Institutional Investment Framework

Source: Casey Quirk (Note Not to Scale)

The key point in this is that the way institutional investors see how they can use hedge funds is changing. It was hedge funds as part of an alternatives category - in a segmented ghetto by risk/return. This is changing towards hedge funds as sources of alpha within broader asset categories. Hedge funds are breaking out of the box!

Putting this framework, and the consequent asset shifts, into practise over coming years will not benefit all asset management businesses. Amongst the attributes of the winning asset management firms, according to Casey Quirk and eVestment Alliance, will be

Managers offering non-correlated investments.

Firms offering both "traditional" and "alternative" investments will stand the best chance of providing institutional clients with a total portfolio solution.

Product development and innovation will remain critical competitive differentiators.

The survey collators go on to turn their gathered insights into a product opportunity map – showing where demand for product will be strongest.

2011 Product Opportunity Map

Source: Casey Quirk, eVestment Alliance

It is important to understand that the product opportunity map compares expected search activity for the upcoming year relative to forecast from the previous year. What is clear is that consultants continue to believe that longer-term trends in search activity favour hedge funds, funds of hedge funds, and non-U.S. equities. However, there is a perceived shift in the demand for funds of hedge funds:

"Consultants focused on larger investors, as well as those focused on non-profit funds, expect more searches for direct investments in hedge funds than they did in 2010. This reflects three realities.

First, most North American institutional investors selected a core fund of hedge funds in recent years, and few are yet convinced they need a change.

Second, and more importantly, larger investors now seek more specialized FOHF strategies in place of, or in addition to, a diversified FOHF mandate. This challenges many FOHF vendors who do not offer a focused product.

The trends identified by the survey authors will likely persist for some years, as allocations in pension plans change slowly, and allocations to hedge funds are going up – doubling in some forecasts. So hedge fund capital flows should be positive at the industry level on a multi-year outlook. There is still a role for funds of hedge funds serving American institutions, and indeed there should be growth in assets this year and next for funds of hedge funds as a whole. But to benefit from those allocations funds of hedge fund businesses are going to have to be in the top quintile of performance ranking over 5 years, and in 2008 specifically, or have a very good specialised product (by geography or investment strategy) to offer.

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